Educational Articles

Stock Screen: Growth Stocks - January 25, 2012

Geoffrey C. Bell
| January 25, 2012

Issues defined as “growth stocks” have a number of common traits, but the most important is that their earnings are expected to grow at a faster pace than the broader market over a period of time. With that in mind, Value Line runs a screen in its Summary and Index that searches for stocks that meet this key criterion. It focuses on issues that have recorded good per-share earnings gains in recent years and that ought to continue to do so in the future, such as ResMed, Inc. (RMD) and Cree, Inc. (CREE).

To make our list, a company's annual growth of sales, cash flow, earnings, dividends and book value must together have averaged 10% or more over the past 10 years and be expected to average at least 10% in the coming 3-5 years, which is no easy feat considering that this time span included varying rates of economic growth. Below we highlight some of the stocks from our screen with sound investment merit:

LEDs present numerous advantages over traditional lighting sources, including energy savings, extend life, lower total cost of ownership, and a reduced impact on the environment compared to fluorescent and compact fluorescent technologies that contain mercury. Cree says its bulbs are 82% more energy efficient than traditional varieties and believes they reduce glare – making food and merchandise more attractive. On the downside, LEDs powerful enough for room lighting are relatively expensive in terms of upfront costs.

A substantial portion of Cree’s products are sold to distributors, that stock inventory and sell to customers such as end users, value added resellers, and manufacturers incorporating Cree’s products into their own goods. Cree has historically had its revenues concentrated in the hands of a few key customers. Indeed, in fiscal 2011, two companies, Arrow Electronics, Inc. (ARW) and World Peace Industrial Co., Ltd. accounted for 20% and 10% of total sales, respectively. Most revenues are derived from international customers. In fact, domestic sales accounted for only 24% of fiscal 2011 revenue, while Asian business was 54% of the top line.

Cree recently released earnings results for its fiscal second quarter ended December 25, 2011 that matched our call of $0.25 a share. The top line came in slightly under our forecast, though, but landed within management’s guidance of between $300 million to $320 million. Additionally, margins have been under pressure from some average selling price (ASP) erosion of late.

Visibility into when LED lighting will hit an inflection point is low at present. The company is making progress towards this end, however, as evidenced by Wal-Mart (WMT - Free Wal-Mart Stock Report) using its products in 650 of its stores. Too, China recently completed its largest highway lighting upgrade with more than 10,000 street lights featuring more than a million Cree LEDs.

With valuations currently at historical lows, we project above average appreciation potential for the stock over the next three to five years. Indeed, the quotation has tumbled by about 60% in the past year, and we see limited downside at this juncture. Thus, patient investors could be rewarded with solid gains out to mid-decade. Leaner inventories and improved cash flow support our rosy long-term outlook.

ResMed Inc. is a developer, manufacturer, and distributor of medical equipment for treating, diagnosing, and managing sleep-disordered breathing (SDB) and other respiratory disorders. The company was formed in 1989 to commercialize a new treatment for obstructive sleep apnea (OSA), continuous positive airway pressure (CPAP), whereby pressurized air is delivered to prevent the collapse of the upper airway during sleep. Since its inception, the company has added substantially to its product pipeline treating SDB, and offers a number of innovative tools such as airflow generators, diagnostic products, mask systems, headgear, and other accessories.

ResMed has grown through a combination of geographic expansion, increased awareness of respiratory conditions, and its research and product development efforts. The company operates as one unit, given its single market focus and the interdependence of its products. It sells its devices in over 70 countries through a combination of wholly owned subsidiaries and independent distributors.

It is estimated that one in five adults suffers from some form of OSA, representing 40 million people in the United States alone. However, because of a general lack of awareness among the public and the medical community, it is thought that less than 10% of those have been diagnosed or treated. Therefore, as consciousness of sleep conditions becomes more widespread, there is ample room for solid market growth down the line, in our view. The company has a record of strong sales growth and has improved the top line by an average of 14% a year over the past four years. Further, its commitment to innovation should keep these trends moving, as 12% of its employees and 7% of revenues were devoted to research and development in fiscal 2011.

ResMed has been buying back its stock at a rapid pace, having repurchased 4.4 million shares during the September quarter as part of the company’s capital management program. We expect ResMed to have reduced the float even further in the December period, demonstrating a commitment to shareholder value. We project potentially good appreciation over the next three to five years. Low debt levels are another positive. Note: ResMed is scheduled to release December quarter earnings on January 26, 2012 after market close.

At the time of this article's writing, the author did not have positions in any of the companies mentioned.